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2 Stocks That Are Wasting Your Money

And one that isn't.

According to research conducted by Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by about 2% to 4% more than it otherwise would have over the ensuing six months.

But over the long term, multiple studies argue that buybacks destroy shareholder value. Famed CNBC pundit Jim Cramer cites the example of big banks that bought back shares in 2007-2008, just before their stocks fell off a cliff. Cramer dismisses the concept of buybacks as buy signals, calling them "a false sign of health ... and often a waste of shareholders' money." The Financial Times recently warned that "the implied returns over a period from buy-backs by big companies would have been laughed out of the boardroom if they had been proposed for investment in ... conventional projects."

So why do buybacks at all? According to FT, management can use them to goose per-share earnings, which helps CEOs earn bonuses based on "performance." Also, the investment banks that run buybacks for management get fees and other income from promoting buybacks. But you and me? We miss out on gains unless those purchases cost less than the intrinsic value of the shares.

And we're about to miss out again.

Two bad buybacksStreetInsider.com keeps a running tally of which companies are buying back stock, and how much they're spending. SI is too polite to accuse companies of actually wasting shareholders' money, but I'm not. With SI's help, I've come up with two examples of popular stocks that I believe are squandering shareholder dollars on ill-timed buybacks ... and one that isn't.

Intuitive Surgical(Nasdaq: ISRG) I doubt I'm going to make many friends with this first antirecommendation. Long a popular stock here at the Fool, and one of the very best performers at the Motley Fool Rule Breakers service, Intuitive Surgical has gone on a monster run over the past year, thrashing the Dow Jones Industrial Average's (INDEX: ^DJI) returns and trouncing the S&P 500 average by 53 percentage points.

But that's just the point. After rising so far, so fast, Intuitive is anything but a bargain today. At 37 times earnings and 34 times free cash flow, the shares appear to "bake in" expectations of growth at the 40% pace Intuitive achieved over the past five years. Problem is, analysts believe this growth rate will fall by half, to less than 20%, over the next five years. And so I ask you: Is now really the best time to rush out and spend $500 million more on share buybacks?

That's what Intuitive intends. Seems to me, though, that Intuitive might be better off spending its cash to "buy growth." $500 million would be more than enough to take control of robotic surgery peer Hansen Medical(Nasdaq: HNSN), for example. It would make for a nice down payment on MAKO Surgical(Nasdaq: MAKO), as well. And sales at both of these companies are expected to outgrow Intuitive by wide margins in coming years.

Starbucks(Nasdaq: SBUX)Our second candidate for share-repurchase profligacy this week is another stellar performer. Last week, Starbucks exceeded expectations with a fiscal Q4 report of 9% same-store sales growth and a 28% improvement in earnings. Management followed up on its report with a promise to buy back 20 million shares -- which at today's price equates to an $880 million repurchase plan.

But again, the shares come at a steep price: 29 times earnings and more than 30 times free cash flow. To me, this looks like an even more egregious waste of shareholder money than we saw at Intuitive Surgical, because Starbucks is growing slower (about 17% annually, projected) and has grown slower for years (about 16% annually). While it's possible the company's tie-up with Green Mountain CoffeeRoasters(Nasdaq: GMCR) will juice the growth rate, I suspect that with all the publicity surrounding that deal, any Green Mountain growth to be had is already factored into analyst projections. At this price, I believe a dividend increase would be a better use of Starbucks' cash.

A better use of cashSpeaking of better uses of cash… Did you hear that AIG(NYSE: AIG) is back and restructured? And that it's repurchasing $1 billion worth of its stock? It's true, and it's attractive.

By my calculations, the stock trades at less than five times trailing earnings today. AIG shares have come a long way (down) since their "re-IPO" back in May. Moreover, analysts think AIG will grow its profits at about 10% per year over the next five years, which gives the stock an ultracheap PEG ratio of about 0.5 -- curiously close to the firm's price-to-book value ratio.

I think that's cheap, and I'm not the only one. Reports suggest that federal government officials will shelve plans to sell the 77% of AIG that the Treasury still owns. Citing a desire to get to at least breakeven on their $28.73-per-share "investment" in AIG, the feds are apparently saying AIG shares are simply too cheap to sell today.

Author

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.